It’s looking more and more to me as if the Fed is being paralyzed into inaction by worries about two possible negative effects of beginning to raise rates now. The dilemma is that the current zero interest rate policy is playing a large role in making each situation worse.

The IMF is arguing that economies in the emerging world are too fragile at present to withstand even a small rate rise in the US. The agency points out that many emerging economies are very dependent on dollar-denominated natural resources, and therefore are being hurt badly by the current slump in demand for minerals. In addition, many have borrowed heavily in US dollars to finance industrial (read: natural resources) capacity expansion. Even a small rise in US interest rates, the IMF says, could spark a sharp upward spike in the value of the dollar against other currencies. This would further dampen demand for natural resources. At the same time it would make the local currency cost of dollar-denominated loans skyrocket, possibly into impossible-to-repay territory. In other words, the Fed could trigger an emerging market crisis similar to the one in smaller Asian countries in the late 1990s.

Of course, what made natural resources firms so foolish as to create wild overcapacity? …one big reason has been the availability of cheap (by historical standards) dollar-denominated loans. What has prompted (and continues to prompt) US investors (among many others) to take the risk of lending crazy-large amounts of money for projects in places they know nothing about and for projects they didn’t understand …years and years of low interest rates on Treasury securities and other safe alternative caused by the Fed’s intensive-care low rates.

The Fed has carefully studied the failure of Japan in the early 1990s to reignite economic growth after its economic meltdown in late 1989. The key factor there, in the Fed’s view (mine, too, for what that’s worth) was that the country tried to remove policy stimulus too soon. The Fed knows that it has already used up all its economy-healing power, so the country would be reliant on Washington for fiscal stimulus to rescue us in the event it makes a similar mistake. But we all know that Congress has a poor track record for corrective action in crisis and is particularly dysfunctional now. So the price to the economy of acting too soon could be very high.

How is it, though, that Congress has been able to ignore its economic responsibilities for so long? …it’s at least partly due to the fact that the Fed continues to cover for lack of legislative action by running a super-easy monetary policy. The Fed is an enabler.

my thoughts

Neither threat to policy normalization–the potential effect on emerging markets and the lack of an economic backup–is going to go away. Arguably, the situation will deteriorate the longer the Fed waits. I think the Fed should start the normalization process now.